Additional

Material: Chapter 3.

Expenditure multiplier

Equation (3.28) states that the equilibrium level of national income, Ye , is a multiple of
C 0  I 0 . That is,

1
Ye  . (C 0  I 0 )   . (C 0  I 0 )
1 b

where the multiple is,

1
 (3.30)
1 b

The multiple,  represents the expenditure multiplier, (pronounce  as ‘alpha’).

The equilibrium level of national income increases or decreases as the size of  increases or
1
decreases. In this example, since   , ( is seen to depend on b only), the easiest way
1 b
to ‘observe’ the relationship between  and b is to take several values of b, within the range,
0 < b < 1, and calculate the corresponding values of , such as those given in Table 3.1.

Table 3.1 Relationship between the expenditure multiplier and MPC, b

b 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90

 1.11 1.25 1.43 1.67 2.00 2.50 3.33 5.00 10.00

From the table it is observed that as b increases over the range, 0 < b < 1,  increases.
Observe that changes in b are accompanied by even greater changes in . For example, when
b increases from 0.8 to 0.9,  increases from 5 to 10. Worked Example 3.17 examines the
implication of this on the equilibrium level of national income.

Government expenditure and taxation: E = C + I + G

The government influences the level of national income in an economy in two ways:

1. Through the level of government expenditure on goods and services, G. It is assumed that
government expenditure is autonomous (fixed). Therefore G  G 0 .
Government expenditure will increase the level of national income (for any given value of
the expenditure multiplier) through its effect on the value of the autonomous components
of expenditure. That is,

1
Ye  . (C 0  I 0  G 0 )
1 b

 
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 Additional Material: Chapter 3.

2. Through taxation, denoted by the symbol, T, which is assumed to be a fixed rate of

T
income; therefore, T = tY, where t is the marginal propensity to tax: t  MPT  and
Y
0 < t < 1. The latter measures the fraction of income which is paid as taxes for each unit
increase in income. The imposition of taxes will reduce the level of national income (for
any given value of expenditure) through its effect on the value of the expenditure
multiplier.
(Note: Tax may also be a lump sum tax,  T 0 ).

When tax is imposed, consumption expenditure is a function of disposable income, Yd ,

where,

Yd  Y  T  Y d  Y  tY  Y d  (1  t )Y

The consumption function is now written as,

C  C 0  bYd
 C 0  b(1  t )Y ... substituting in Yd  (1  t )Y

Note: With taxes the slope of the consumption function, b(1 - t) decreases; since b(1 - t) < b.
The equilibrium condition is now given as,

Y  E  C I G
 C 0  b(1  t )Y  I 0  G 0

Solving the equilibrium equation for Y gives an expression for the equilibrium level of
national income for the given three sector economy,

Y  b(1  t )Y  C 0  I 0  G 0
Y[1  b(1  t )]  C 0  I 0  G 0
1
Ye  . (C 0  I 0  G 0 ) (3.31)
1  b(1  t )

Expenditure multiplier with taxes

With taxes, the expenditure multiplier is,

1
 
1  b(1  t )
(3.32)
The inclusion of taxes reduces the value of the expenditure multiplier.
The equilibrium level of taxation is calculated from the equilibrium level of income, that is,

T e  tY e (3.33)

 
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 Additional Material: Chapter 3.

Graphically, the equilibrium level of taxation occurs at the point of intersection of the
taxation function, T = tY and the vertical line, Y  Y e .

Foreign Trade

The foreign trade sector influences the level of national income in an economy in two ways:
1. Through the level of foreign expenditure on domestic exports, X. Exports are
assumed to be autonomous (fixed) and the export function is given as, X  X 0 .
Foreign expenditure on domestic exports will increase the level of national income
through its effect on the value of the autonomous components of expenditure.

1
Ye  . ( C 0  I 0  G 0  X 0) (3.34)
1  b(1  t )

2. Through the level of domestic expenditure on imports, - M. The import function is

given as,

M  M 0  mY (3.35)

where M 0 is autonomous imports and m is the marginal propensity to import,

M
m  MPM 
Y

The equilibrium condition is now given as,

Y  E  CI G X  M

 C 0  b(1  t )Y  I 0  G 0  X 0  M 0  mY

Solving for Y, the equilibrium level of national income is,

1
Ye  . (C 0  I 0  G 0  X 0  M 0 ) (3.36)
1  b(1  t )  m

Expenditure multiplier with foreign trade

With foreign trade, the expenditure multiplier is,

1
  (3.37)
1  b(1  t )  m

The inclusion of the foreign sector reduces the value of the expenditure multiplier.

 
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 Additional Material: Chapter 3.

Summary:

The effects of the components, C, I, G, X, M on the multiplier and the equilibrium level of
national income are summarised in Table 3.2.
Note: Ye  means Y e decreases; Ye  means Y e increases etc.

Table 3.2 Summary of national income model

Expenditure: E Equilibrium level of income: Y e Multiplier:  Comments

(Reduced form)

C 0 + bY + I 0
Ye 
1
(C 0  I 0 ) 
1  As b  ,   .
1 b 1 b
 As b  , C 0  ,

I 0   Ye  .

C 0 + bY + I 0
Ye 
1
(C 0  I 0  G 0 ) 
1 As G 0  , Ye 
1 b 1 b
+ G0

C 0 + b(Y - tY) +
Ye 
1
(C 0  I 0  G 0 ) 
1 As t  ,   : Ye 
1  b(1  t ) 1  b (1  t )
I 0 + G0

C 0 + b(Y - tY) + Ye  1 As X 0  , Ye 

1 1  b (1  t )
(C 0  I 0  G 0  X 0 )
I 0 + G0 + X0 1  b(1  t )

C 0 + b(Y - tY) + Ye   As M 0  , Ye 
1 1
(C0  I 0  G0  X 0  M 0 )
I 0 + G0 + X0 1  b(1  t )  m 1  b (1  t )  m As m  ,   :

 M 0  mY Ye  .

 
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 Additional Material: Chapter 3.

3.4.2 IS-LM model: determination of equilibrium national income and

interest rates

The IS-LM model is now developed and then used to determine the equilibrium level of
national income and the equilibrium interest rate in an economy.

IS schedule

The IS schedule relates all possible values of Y (national income) and r (interest rates) for
which equilibrium exists in the goods

market. So far, investment has been assumed to be autonomous; however, in reality,

investment is influenced by the level of interest rates, r. As interest rates increase, investment
decreases; therefore, the investment function is given by,

I  I 0  dr (3.38)

where d is a constant.
With interest rates, the equilibrium condition for the three-sector economy (no foreign sector)
is,
Y  C  I  G0
 C 0  bYd  I 0  dr  G 0 (3.39)

Writing equation (3.39) in the form, r = f(Y) gives the equation for the IS schedule.

LM schedule

The LM schedule relates all possible combinations of Y (national income) and r (interest
rates) for which equilibrium exists in the money market. Money market equilibrium exists
when money supply is equal to money demand, that is,
Ms  Md (3.40)
At any given time, money supply is constant; therefore,

Ms  M0 (3.41)

Money is demanded for transactionary, precautionary and speculative purposes.

Transactionary demand, M dT , facilitates the everyday purchase of goods. Precautionary

demand, M dP , facilitates unforeseen expenses that may occur. Assuming that the sum of
both these demands is proportional to national income, where k is the positive constant of
proportionately and letting, L1  M dT  M dP , then,

L 1  kY 0 k 1 (3.42)

 
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 Additional Material: Chapter 3.

Speculative demand, M dS , facilitates speculations (investments) in other assets such as

government bonds, that is, the idle money that is not used for either transactionary or
precautionary purposes can be used for speculative purposes. The level of speculations is
negatively to the interest rate, r. [See Chapter 5.5].
Letting L 2  M dS , then the speculative demand for money can be modelled as,

L 2  a  hr (3.43)

where a is a positive constant and (- h) is a negative constant (h > 0).

Overall, the total demand for money is given as,

M d  M dT  M dP  M dS  L1  L 2  kY  (a  hr ) (3.44)

Therefore, money market equilibrium is given by,

M s  Md
M 0  kY  a  hr (3.45)

Writing equation (3.45) in the form, r = g(Y) gives the equation for the LM schedule.

Equilibrium national income and equilibrium interest rate

The goods and money markets are simultaneously in equilibrium for the values of r and Y
which satisfy the simultaneous IS and LM equations.

 
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